MY TAKE - Where was the watchman?

Monday

Sep 29, 2008 at 12:01 AMSep 29, 2008 at 6:17 AM

The sub-prime mortgage debacle raises a very important question: Why would otherwise conservative bankers and investors get themselves involved in such foolish ventures? The answer lies in a very basic principle of economics — the relationship between risk and reward.

Reward is what motivates us to take a risk, and risk is what causes us to proceed cautiously when seeking a reward. When we see otherwise prudent individuals behaving in a manner that betrays this principle, we can be sure that something is fundamentally wrong.

RICK HARRELL

The sub-prime mortgage debacle raises a very important question: Why would otherwise conservative bankers and investors get themselves involved in such foolish ventures? The answer lies in a very basic principle of economics — the relationship between risk and reward.

Reward is what motivates us to take a risk, and risk is what causes us to proceed cautiously when seeking a reward. When we see otherwise prudent individuals behaving in a manner that betrays this principle, we can be sure that something is fundamentally wrong.

In 1977, a bill with the innocuous title “Community Reinvestment Act” (CRA) was signed into law by President Carter. This made it possible for some people who previously didn’t qualify for a home mortgage to become homeowners. Revised in 1992 and 1995, CRA led to the ascendancy of the now infamous Fannie Mae and Freddie Mac, which eventually became involved in 70 percent of all mortgages in the United States. Because Fannie and Freddie were pseudo-government agencies it was assumed that all of these risky loans were “guaranteed.” Fannie and Freddie took these mortgages, bundled them together and pawned them off as AAA-rated securities. Lenders and investors were led to believe that their risk was covered by the federal government, which eventually led to a feeding frenzy. Suddenly there was a giant pool of home buyers that never existed before. Practices such as no-down-payment, NINA (no income no asset verification) loans, and mortgages for more than the value of the home became common practice.
When you throw in deregulation and virtual lack of oversight for Fannie Mae and Freddie Mac, you now have a perfect recipe for disaster.

All of this begs the question: Where were the Federal Reserve chairman, the Treasury secretary, the head of the Securities and Exchange Commission, Congress and the president while these events were taking place? Where was the watchman on the wall warning us of what was to come? The American people should demand regulations that are based on sound economic principles.

Obviously, thousands of people who knew better stood idly by while all of this transpired, because there was money to be made or their political ideology was being played out. Because of that the U.S. taxpayers are about to become the proud owners of $700 billion worth of bad paper.